Too Rich For My Blood: Private Equity Balks at Sky-High Valuations

As 2015 valuations have reached record levels, private equity firms around the world are facing a serious case of sticker shock. Unlike other M&A booms, where private equity has been a driving force, today’s deal environment is dominated by large corporate buyers catapulting deal volumes (and valuations) to near record levels. This aggressive behavior has, in turn, resulted in a sharp decline in overall private equity deal activity.

This year, though, global deal-making is on pace to eclipse pre-crisis levels, and, unlike the 2007 M&A boom which was characterized by mega-LBOs, the vast majority of deal flow is coming from corporate takeovers. According to recent data from Dealogic, only 5% of the $2.6 trillion of deals announced this year as of August 3 were private equity backed, down from 9% as of August 3 last year, and the lowest percentage for any similar period in 14 years.¹ In the U.S., PE firm activity fell 19.2% month over month, with 97 deals announced in July and 120 the month before.²

The decline in private equity activity is primarily fueled by hard-to-justify, near-record valuations. In fact, valuations are forecasted to reach to new highs after rising to an average of 16.5 times EBITDA in the U.S. during the first half of the year, according to data company Intralink’s Deal Flow Predictor. Deals over $1 billion—which have become commonplace in today’s M&A market—carry an even higher median valuation of 19 times EBITDA.³ Private-equity firms are finding it tougher to pay up for companies with these sky-high valuations, although it’s not for lack of trying. Buyouts firms have paid on average more than 10 times EBITDA so far this year, the highest purchase price multiple in about 20 years, according to Standard & Poor’s Capital IQ’s LCD. Strategic buyers, on the other hand, have taken advantage of the buoyant stock market and are utilizing their powerful currency to complete acquisitions.

Competition from corporate acquirers has also helped drive purchase prices upward and sideline potential private equity acquirers from participating in 2015’s largest transactions. Strategic buyers are typically more motivated than PE firms as a result of pressure to achieve inorganic growth, coupled with significant cash reserves. Competitive corporate acquirers can also justify higher bids because of synergistic opportunities and less reliance on financial engineering to achieve their goals. As such, they’re able to bid aggressively, pushing deals out of reach of interested PE buyers. For example, buyout firms were reportedly outbid in Home Depot Inc.’s $1.63 billion deal announced in July to buy Interline Brands Inc. as well as Jarden Corp.’s $1.35 billion agreement to purchase disposable tableware-maker Waddington Group Inc.4

In a deal-making environment characterized by mega-mergers, some targets are still just too large for private equity firms. CDK Global Inc., a provider of information technology to automobile dealers, could be one of those. According to Bloomberg, the company is currently exploring a sale to private equity firms at a purchase price of over $11 billion. While this number may not seem high for corporate acquirers, no one has attempted a buyout of that size in the U.S. since 3G Capital agreed to buy H.J. Heinz Co. for more than $23 billion in 2013.5

Private equity firms are also struggling to raise money in the debt markets, limiting their ability to effectively compete with corporate buyers. For example, regulators recently issued guidelines prohibiting banks from financing takeovers where debt exceeds six times EBITDA. In today’s environment, this often results in a sizeable funding gap. Total debt used to fund large LBOs was on average 5.6 times debt-to-EBITDA in Q1, down from as high as 6.3 times in the three months through September, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data. That crackdown on leveraged lending could also be affecting the appetite of PE buyers.

While these roadblocks may be challenging to overcome, private equity buyers are still getting deals done. For example, Norton, the antivirus software maker owned by Symantec, has agreed to sell its data storage unit, Veritas, for $8 billion to a group led by Carlyle Group LP in the biggest U.S. leveraged buyout deal of the year.6 Additionally, some buyers seeking lower valuations have been exploring alternate strategies such as purchasing minority stakes, employing the “buy and build” approach of making add-on investments to complement a company they already own, or refocusing their efforts on the middle and lower-middle-markets. It’s clear that private equity firms are feeling the pressure to put their record levels of dry powder to work, but they remain cautious in order to avoid overpaying for deals and being left with a bad case of buyer’s remorse.

I would be remiss not to mention the potential impact the recent market volatility could have on private equity deals. We suffered an over 10% correction in the equity market last month, and stocks have suffered a rough start to September as well. With prices coming down a bit, we may see renewed PE activity, but it’s the underlying causes of this volatility that could ultimately have a greater impact on deal-making. One of the more significant drivers of today’s M&A boom is a general feeling of confidence surrounding the economic environment. However, factors such as the Chinese economy, August equity correction and Fed’s looming decision on interest rates are shaking the confidence of potential buyers and sellers. Ultimately, we will need to wait and see if the new trading levels energize the PE community, or if these concerns are enough to put a damper on deal activity.